How the Absolute Priority Rule Affects Chapter 11 Plans

In a Chapter 11 bankruptcy, creditors are generally entitled to repayment of some of the outstanding debts and obligations. However, not all obligations are treated equally. Creditors as well as equity holders are paid in accordance with the absolute priority rule, which sets a hierarchy for the fair and equitable distribution of debt repayments. To obtain court approval, a Chapter 11 plan must call for following this order of payment.

The absolute priority rule means that lower ranking claim holders cannot recover payments unless each class of higher ranking recovers their fair share. The order of payment priority is codified in the bankruptcy code as follows, from highest to lowest:

• DIP loans — Debtor in possession (DIP) loans enjoy “super priority” status. These obligations are created when a lender agrees to provide short-term financing to a debtor company in Chapter 11. DIP loans are designed to give the borrower sufficient funds to continue operating as the company reorganizes its debt and seeks to emerge in solvent condition.
• Secured claims — A secured debt is one in which a loan is guaranteed by a pledge of or interest in property. For example, a business loan may be secured by a pledge of the company’s capital equipment or a lien on its real estate. This class of claims is further divided into two others: The first debt secured by a certain asset is called the 1^st A subsequent loan collateralized with the same asset is the 2^nd lien.
• Priority unsecured claims — Unsecured debts are those in which the lender has no collateral. As such, these claims are less likely to be paid. Some unsecured claims have priority, which means they get paid before other unsecured debts. Priority unsecured claims include certain administrative fees, tax obligations and employee claims for wages or benefits.
• General unsecured claims — General unsecured claims are non-priority obligations. Most GUCs are based on contracts between the company and its creditors. As GUCs are further down in the hierarchy, they are even less likely to be paid.
• Preferred equity — Many public and private companies are owned by shareholders or other equity owners. Equity owners have rights to the assets and income of the business. Preferred equity owners are those with higher priority distribution rights.
• Common equity — Common equity owners or common stockholders are those having no special rights. These owners are very unlikely to be paid in a Chapter 11 case.

The hierarchy of payments in Chapter 11 works on the “full bucket” principle. That is all creditors in a higher priority class must be paid in full before any money flows into the next lower class.

The Law Offices of Michael Jay Berger in Beverly Hills files and confirms Chapter 11 plans of reorganization in every district of California. Both Michael Jay Berger and Sofya Davtyan are Certified Specialists in Bankruptcy Law, with wide experience in Chapter 11 matters. If your company is struggling with debt, feel free to contact us online or call 310-271-6223 to schedule a consultation.